Towards Consensus on the
Taxation of Investment
Income
Report to the Minister of Finance and Revenue
By
Craig Stobo
Chair
October 2004
SEMI-KIWI
The barn roof needs painting
and the spouting is ruined.
Likewise the roof of this house
in which we live, borer here,
rot there. I’m neither handy,
in the great Kiwi DIY tradition,
nor monied, which rather leaves
us up shit creek without a shovel.
I grub to find what Stevens called
the ‘plain sense of things’
and come up empty-handed
more often than not, but
I’m a dab-hand at recognising,
if not suppressing, self-pity,
and I can back a trailer
expertly, so all is not lost.
Brian Turner
Te Mata Estate New Zealand Poet Laureate
(Reprinted from “Taking Off”, Victoria University Press, 2001,
with kind permission of the author)
Contents
Foreword
Chapter 1
Executive summary
1
Chapter 2
Taxation of investment income – principles and practice
2
Chapter 3
The impact of the current tax boundaries
7
Chapter 4
Options for reform
14
Chapter 5
Stakeholder reaction
24
Chapter 6
My view of the options and recommendations for change
28
Chapter 7
Next steps
34
Appendix I
Terms of Reference
35
Appendix II
Stakeholders consulted
37
Appendix III
“Financial systems and economic growth: An evaluation
framework for policy” – a summary
38
Appendix IV
Background to the tax rules for CIVs
41
Appendix V
Working for Families – effective marginal tax rates, and
abatements
45
Glossary
47
Foreword
I consulted a large number of stakeholders during this consensus building process.
They represented a range of interests reflecting the breadth of the investment and
savings industry in New Zealand. The basis for my engagement was not that New
Zealand necessarily has a poor savings rate, but that taxation is distorting the efficient
allocation of what savings New Zealanders do have. Taxation rules are necessarily
arbitrary, but in the case of the taxation of investment income, outcomes have become
sub-optimal, in my judgment, as after-tax return considerations mean investors incur
transactions costs and assume different portfolio risks than would be the case if
investors focused on gross (pre-tax) returns. The optimal allocation of our scarce
capital resources is therefore distorted and New Zealand’s potential growth rate is
arguably lower as a result.
The options developed in this process were designed to reduce both the tax
disincentives prevalent in New Zealand collective investment vehicles (CIVs),
relative to direct investment in New Zealand assets; and the distortions created by our
tax rules favouring a small number of high tax countries (the grey list) for
international portfolio investment in equity. This process did not seek a constituency
to support tax incentives for savings.
In my capacity as Chair I was assisted by David Carrigan, Darshana Elwela, Tracey
Davies, Keith Taylor and Robin Oliver from the Policy Advice Division of Inland
Revenue; and Brock Jera, Felicity Barker, David Snell, Andrew McLoughlin, and
Vicky Robertson from the Treasury. I want to personally thank them for their support
and intellectual integrity during the consultation process. Thanks are also due to the
stakeholders who put aside their self interest, and contributed their time to wrestle
with the issues and the proposed solutions. I hope I have adequately captured their
concerns and aspirations.
I should not neglect the fact that the options presented in this review build on the
generation and exchange of ideas of past contributors to the improvement of public
policy on the taxation of investment income. If I have misrepresented any of their
views I take full responsibility.
Signed
Craig Stobo
29 October 2004
Disclosure: Craig Stobo was formerly the CEO of BT Funds Management Ltd and board member of the Investment, Savings and
Insurance Association of New Zealand. He is currently deputy chairman of Industrial Research Ltd. He contributed to the
Periodic Report Group, Savings New Zealand and the officials’ issues paper, Taxation of non-controlled offshore investment in
equity. He has worked as an independent contractor for this consensus building process. He has financial interests in direct
shares, direct property and CIVs.
Chapter 1
Executive summary
The Government has asked me to “develop options for change that would minimise
the extent to which the tax system distorts the way New Zealanders invest (direct
versus via an intermediary or via different intermediaries)”.
The Terms of Reference (see Appendix I) restricted the development of options to all
offshore portfolio equity investment, whether direct or through a New Zealand
collective investment vehicle (CIV), and New Zealand CIVs that own domestic
equity. It did not extend to the treatment of debt instruments or New Zealand
equity/property held directly.
This consultation process uncovered a strong consensus to change the way New
Zealand taxes investment income. Therefore the objective of this process was
welcomed by almost all stakeholders. Stakeholders agreed on the tax boundaries
under discussion and the economic distortions that arise from those boundaries, which
affect investor behaviour.
Options presented for improving the taxation treatment of investment income in New
Zealand were agreed by stakeholders as the best set of options available, given my
Terms of Reference. I did not receive any comments or submissions that materially
improved the options presented. Options provided to me on flattening the tax scale
and extending the brief to direct New Zealand assets are economically sound
suggestions but are outside the Terms of Reference.
An analysis of stakeholders’ preferred combination of options shows majority support
for:
a)
A change in the definition of “income” for defined New Zealand CIVs by
shifting the capital/revenue boundary to exclude capital gains on domestic
equity.
b)
The abolition of the grey list and foreign investment fund (FIF) rules for
offshore portfolio equity investment, the removal of dividend taxation, and the
institution of an investment and savings tax (IST).
c)
The alignment of taxation through a New Zealand CIV with investor marginal
tax rates by way of a “flow through” regime.
An analysis of this consensus and my Terms of Reference, which demand
consistency, leads me to differ on the combination of options preferred by
stakeholders. My preference is for an IST to extend to domestic equity held through
New Zealand CIVs, since this gets us closer to the taxation of full economic income
and is consistent with the preferred option for taxation of offshore equity.
I believe there is considerable momentum for change. It is not obvious to me that a
democratic process of consensus building towards an improved sustainable system of
taxation of investment income for New Zealand investors during a clear window of
goodwill can be surpassed as a strong process for change.
1
Chapter 2
Taxation of investment income – principles and
practice
In the course of the consultation process it became clear that sections of the
investment community sought clarification on what it was I was trying to solve. I
hope the following articulates the issues clearly.
THE TAXATION OF INVESTMENT INCOME
The guiding principle of income tax policy is to tax an economic definition of income.
The most common definition of income, attributable to Haig-Simons,1 is the change in
market value of net assets for a defined period plus consumption over the same
period. Deviations from this principle would result in some economic activities being
preferred relative to others. Haig-Simons income is therefore the benchmark which I
have used to assess options for taxing investment income in New Zealand.
Unrealised capital gains on net assets under this benchmark are part of economic
income. New Zealand does not have a comprehensive capital gains tax.2 That is not
to say that capital gains taxes are a preferred way of dealing with this anomaly. The
McLeod Review concluded in 2001 that “… New Zealand should not adopt a general
realisation-based capital gains tax. We [the Review] believe that such a tax would not
necessarily make our tax system fairer and more efficient, would not lower tax
avoidance and would not raise substantial revenue that could be used to lower tax
rates. Instead, any such tax would be more likely to increase the complexity and costs
of our system. The experience of other countries (such as Australia, the UK and the
US) supports that conclusion.”3
New Zealand has instead opted for business and purpose tests to define whether
investment is on revenue account, and therefore subject to tax on realised gains, or on
capital account, in which case taxation is not due on realised gains. The tests
effectively try to distinguish between what is the apple tree (untaxed capital) and what
is the apple (taxable income).
1
Haig, Robert M. (editor) (1921), The Federal Income Tax, Columbia University Press, and Simons,
Henry C. (1938), Personal Income Taxation, University of Chicago Press.
2
While capital gains are tax-free in the main, New Zealand deems the proceeds of sale from certain
assets to be income under ordinary concepts.
3
Final Report of the Tax Review 2001 (October 2001).
2
The tests cannot fully be described in legislation. They do, however, have a long
history in the common law. Recently, participants in the investment and savings
industry have had to resort to the judiciary to seek clarity. An example of this
guidance is Alexander and Alexander Pension Plan v CIR.4 Additional common law
guidance comes from CIR v City Motor Services5 and Grieve v CIR.6 None provide
watertight definitions of what is capital and what is revenue. The problems drawing
the boundary between capital and revenue were summed up eloquently as “... an
intellectual minefield in which the principles are elusive and the analogies
treacherous”.7
The major tax-driven side effects from New Zealand’s deviation from the taxation of
economic income are:

Investors’, suppliers’ and advisors’ efforts to mitigate tax liabilities require
expensive tax advice on whether an investment is on capital or revenue account.

Compliance outcomes are asymmetric. Trustees of CIVs with tax liabilities will
tend to be conservative in their definition of income by treating both realised
and unrealised gains on revenue account. This is due to equity issues associated
with pooling and the threat of official audit. Other investors may “game” the
definition and not treat realised gains as income because the threat of official
audit is perceived as low.

Taxpayers can apply to the Inland Revenue for private rulings on whether an
investment is on capital or revenue account in order to gain certainty of tax
treatment. However, these rulings are expensive and time consuming.

Inland Revenue rulings on the interpretation of the capital/revenue boundary in
relation to passive products have also created a tax driven demand for passive
products, which has led to over-investment. This means that companies within
relevant indices may be receiving more capital than is warranted, while others
outside these indices go wanting.

Investors may have a strong preference to own directly high dividend New
Zealand shares, and a bias away from directly owned high dividend shares
offshore. Investments offshore may be directed to growth oriented companies
to minimise double taxation due to their inability to utilise offshore imputation
credits.
4
(1995) 19 TRNZ 884
[1969] NZLR 1010 (CA)
6
(1983) 6 NZTC 61,682
7
Tucker v Granada Motorway Services Ltd [1979] 2 All ER 801; per Templeman J.
5
3

Traditional CIVs migrate to entity forms which replicate the status of direct
investors on capital account such as individually managed accounts, blind trusts
and passive funds, even though the spread of underlying assets may be
equivalent to assets held by more traditional CIVs. While these newer forms
may well have platform technology and client servicing advantages, and
competitive fee structures, it would be a long bow to pull to say that the absence
of a tax on realised gains is not the principal competitive advantage. The
consequences of this shift in form is that compliance obligations are pushed
down to the beneficial investors; and it is not clear that these forms are optimal
channels for lower income savers with small initial balances. If they are pooling
funds (reducing risk and administration costs), then they must have robust
systems of individual investor identification to ensure they do not meet the
definition of “unit trust” in the Income Tax Act.
THE TAXATION OF OFFSHORE PORTFOLIO INVESTMENT IN EQUITY
The taxation treatment of offshore portfolio investment in equity must necessarily
differ from the taxation treatment of onshore portfolio investment, because the New
Zealand Government does not collect taxation from foreign entities, whereas it does
collect taxes from New Zealand entities (e.g. company taxation). New Zealand
investors should regard foreign taxes as simply a cost of investing overseas and
arrange their portfolios to minimise offshore tax accordingly. The New Zealand
Government should be indifferent to capital outflows when New Zealand investors
face an after-tax foreign return that is at least as high as a pretax domestic return on
similar risk-adjusted assets. National welfare is enhanced as a result.
As a net capital importing country, New Zealand should implement this “residence
principle”-based taxation strategy. New Zealand residents should be taxed at the
same rate of New Zealand tax on all sources of domestic and foreign income,
recognising foreign taxes as a cost of doing business by allowing them to be
deductible. Ideally therefore New Zealand tax rules should approximate the afterforeign tax income earned by the foreign entity and attribute it to the New Zealand
investor.
Currently the New Zealand tax rules deviate from this principle. Two sets of rules
apply to offshore portfolio investment. Non-grey list countries are subject to the
foreign investment fund (FIF) rules. These rules generally apply the residence
principle by taxing, on an accrued basis, the investor’s economic income derived from
the foreign entity. They therefore get fairly close to Haig-Simons income. However,
the four income calculations available to FIF investors are costly to comply with, have
harsh cashflow consequences in certain circumstances and have timing disadvantages.
4
The grey list refers to investment in seven countries – Australia, the United Kingdom,
Canada, Norway, the United States, Germany and Japan – which, because of the
similarity of their tax systems to that of New Zealand, have achieved a concessionary
treatment resulting in a tax preference for New Zealand investors. Grey list nonbusiness investors (who generally argue that they invest on capital account) are
generally only required to pay New Zealand tax on dividend income. It is therefore
not surprising to learn that around 80% of offshore portfolio investment occurs in grey
list countries. From an economic perspective, quite why any of these investment
destinations (least of all Norway) should receive tax preferences over non-grey list
destinations such as France or China is illogical. The current country composition is
economically meaningless. Our tax rules should encourage New Zealand investors to
focus their foreign portfolio decisions on income net of foreign tax paid, relative to
gross returns available from portfolio investments onshore. Furthermore, effective tax
rates (on economic income earned by New Zealanders after foreign tax) can diverge
significantly from an equivalent pre-tax domestic investment.
THE TAXATION OF ENTITIES
Entities, or more specifically CIVs, such as investment companies, unit trusts and
superannuation schemes are economic agents of their owners. Entity taxation is
economically a tax on the beneficial owners of entities. After all, entities do not
derive economic income – their beneficial owners do. Entity taxation should
therefore reflect the marginal income tax rate of the ultimate investor.
In New Zealand the corporate tax regime places a single withholding tax on the
company on behalf of the ultimate investors. Our imputation regime provides a
mechanism to align our progressive income tax rate scale with the withholding tax
levied in the entity. The more progressive the income tax scale becomes, however,
the more advantages accrue to taxpayers on higher marginal tax rates (in terms of
timing of final tax payments); and the more disadvantages accrue to those on lower
marginal tax rates (in terms of timing and potential use of excess imputation credits).
With regard to New Zealand CIVs such as superannuation schemes, where the final
33% tax liability resides inside the vehicle (and therefore there is no imputation
regime) there is no alignment with taxpayers on 19.5% or 39% marginal tax rates.
Investors on 19.5% face tax penalties while those on 39% receive a tax incentive.
It is difficult to find evidence that differences between entity and marginal tax rates
drive investor behaviour. The anecdotal evidence suggests 39% investors prefer
direct investment (due to the treatment of capital gains). Investors on 19.5%,
however, not only find it difficult to save, face the same capital gains hurdle, but also
face the additional hurdle of over-taxation in the entity. (The interaction of the tax
system with the benefit regime is important. See Appendix V.) Furthermore, taxexempt entities, such as charities, find it very difficult to align their tax status with the
taxation of CIVs.
5
The tax treatment of CIVs that potentially hold the same underlying assets should be
equivalent. Currently taxation regimes differ for unit trusts, GIFs, life products and
superannuation (see Appendix IV). This is not efficient when the vehicles may hold
exactly the same assets. Real economic costs are incurred by the ultimate saver or
investor as they or their advisors search for and select the most tax effective entity.
6
Chapter 3
The impact of the current tax boundaries
THE DEFINITION OF “INCOME”
The capital/revenue boundary receives a conservative treatment by almost all New
Zealand CIVs. As a result almost all CIVs provide for tax on realised and unrealised
capital gains at 33%, despite the absence of a legislated capital gains tax in New
Zealand. The principal reason for this is that, in the absence of clear legislation or
judicial rulings on the business and purpose tests, trustees opt to treat all gains on
revenue account. To do otherwise could introduce inter-temporal inequity between
classes of investors should the Inland Revenue be successful in challenging a capital
account tax treatment. Those investors that exited prior to the successful challenge
would escape any tax liability.
As noted in the previous chapter, the economic impact of this boundary is threefold.
Firstly, the treatment of capital gains inside CIVs is a major turnoff to all investors
who have the opportunity to invest directly in the same underlying assets on capital
account. Secondly, the direct channel is not easily accessible to investors with small
initial balances and small amounts of regular savings. Thirdly, the direct channel
clearly favours investors with existing accumulated capital. Figure 1 illustrates why
direct investment in a New Zealand share is preferable for a 39% investor on capital
account relative to investing in the same share through a unit trust.
Figure 1: Direct/indirect investment boundary
INVESTMENT VIA A UNIT TRUST
$100K
$100K
$6.7K+$3.3K ICs
$10K TCG
NZ Investor 39 % C/A
NZ Unit Trust R/A
NZ Co
Dividend of $10K = $6.1K in pocket
KEY
IC – imputation credits
C/A – capital a/c
R/A – revenue a/c
TCG – taxable capital gain
NTCG – non-taxable capital gain
7
COMPLIANT DIRECT INVESTMENT ON C/A
$100K
$10K NTCG
NZ Investor 39% C/A
NZ Co
= $10K in pocket
In addition, there has been a rapid increase in investor interest in the provision of
investment management services on capital account which effectively push the
liability for tax to the investor. These new services include individually managed
accounts, blind trusts and passive funds with Inland Revenue rulings. In relation to
passive funds, their tax-favourable investment has seen a rapid growth in their
popularity from 1996 (the year that the first Inland Revenue ruling was granted).
There is now estimated to be around $5.5 billion in passive funds.8 Tax is creating a
wedge against the use of pooled investment services, which have become relatively
tax-disadvantaged.
I do not want to belittle the real advantages that these innovations may provide in
terms of service, choice, fees, and investment performance. However, tax is clearly a
major competitive advantage, and the ability of the Inland Revenue to monitor the end
investor’s compliance with the tax rules is weak. Table 1 details the latest figures for
the net wealth of New Zealanders by asset type.
8
8
According to FundSource Research Ltd.
Table 1: Intermediated assets versus direct assets versus total assets of New
Zealanders9
Asset Type
Pop with asset
%
Total value Prop of total
(million) $ asset value %
Median
$
Maori Assets
3
8,790
2
15,000
Trusts
4
28,709
6
216,000
Farms
4
38,257
9
350,000
Businesses
12
38,574
9
43,000
House living in
48
159,205
36
160,000
Time share
1
137
0
8,000
Holiday home
2
4,361
1
80,000
Rental property
6
18,887
4
135,000
Overseas property
1
4,194
1
40,000
Commercial property
2
7,343
2
150,000
Other property
4
9,863
2
95,000
Superannuation
21
24,737
6
25,000
Life insurance
14
8,797
2
15,000
Credit cards (positive balances)
3
95
0
500
Bank deposits (including bonus
bonds)
91
26,000
6
2,300
Shares
21
13,986
3
5,000
Managed funds
9
11,864
3
23,900
Other financial assets
5
5,792
1
30,000
Money owed to respondent
8
3,835
1
5,000
77
16,871
4
8,000
3
191
0
1,600
Collectibles
25
6,857
2
5,000
Other assets
44
6,685
2
3,000
Motor vehicles
Cash
Total
444,030
125,300
ONSHORE/OFFSHORE BOUNDARY
The offshore tax rules encourage the migration of offshore portfolios from New
Zealand CIVs with implicit capital gains taxes to foreign CIVs in grey list
jurisdictions on capital account, as depicted in figure 2.
Taken from Statistics New Zealand and the Retirement Commission (2002) “The net worth of New
Zealanders: a report on their assets and debts” available at www.stats.govt.nz and www.sorted.org.nz.
9
9
Figure 2: Offshore/onshore boundary
INVESTMENT VIA A NZ VEHICLE
$100K
$100K
$6.7K NTCG
NZ Investor 39% C/A
$10K TCG
NZ Managed Fund R/A
Italian Co
= $6.7K in pocket
INVESTMENT VIA A GREY LIST VEHICLE
$100K
$100K
$10K NTCG
NZ Investor 39% C/A
$10K NTCG
UK Managed Fund
Italian Co
= $10K in pocket
There are now very few (if any) New Zealand CIVs that hold foreign portfolios
directly as investors and CIV providers prefer foreign CIVs. The migration may be
driven by other factors such as economies of scale, but the tax advantages are too
large to ignore.
This migration to foreign CIVs may not be optimal from a New Zealand portfolio
investor’s perspective. Firstly, foreign CIVs may not manage currency risk from a
New Zealand perspective. Secondly, their world view is not New Zealand-domiciled,
so an international equities portfolio managed principally for Australian investors will
not include Australian stocks but may include New Zealand stocks.
From the Government’s perspective, compliance shifts from New Zealand entities to
New Zealand individuals.
10
THE TAXATION OF OFFSHORE PORTFOLIO INVESTMENT
According to the officials’ issues paper,10 fund managers and other New Zealand
entities manage around $17 billion of offshore portfolio investment. Individuals hold
another $5.5 billion, of which approximately 60% is either invested directly in
Australia or using an Australian entity as a vehicle to invest elsewhere.
The first impact of the preferential tax treatment attached to the grey list is that 80%
of New Zealanders’ portfolio investment goes into grey list countries, a rationale for
which is evidenced in figure 3. This statistic is not necessarily very helpful and will
almost certainly be lower, since in many cases New Zealand portfolio investment into
grey list countries includes intermediate vehicles such as Australian unit trusts and
UK open-ended investment companies which on-invest globally, including into nongrey list stocks. Available data cannot assist officials to look through the intermediate
vehicles to the final investment to determine the actual country exposure of our total
portfolio investment. However, it is interesting to note that the Morgan Stanley
Capital International (MSCI) benchmark country weighting of the seven grey list
countries was 83.6% as at 31 August 2004.
Figure 3: Grey list/non-grey list boundary
COMPLIANT DIRECT INVESTMENT IN GREY LIST COUNTRY ON C/A
$100K
$10K NTCG
NZ Investor 39% C/A
UK Co
= $10K in pocket
COMPLIANT DIRECT INVESTMENT IN NON GREY LIST COUNTRY ON C/A
$100K
$10K TCG
NZ Investor 39% C/A
French Co
= $6.1K in pocket
Taxation of non-controlled offshore investment in equity: an officials’ issues paper on suggested
legislative amendments. Prepared by the Policy Advice Division of Inland Revenue and by the New
Zealand Treasury. December 2003.
10
11
Effectively, New Zealanders are able to access non-grey list stocks through the grey
list and avoid the FIF rules. The original rationale for the grey list (that effective grey
list tax rates approximate New Zealand effective tax rates) has broken down. The
soon-to-be introduced rules relating to offshore unit trusts will remove the ability of
some offshore vehicles to avoid income tax by issuing bonus units in lieu of
distributions. However, the ability to avoid the FIF rules remains because offshore
vehicles can still be used as conduits for New Zealanders to access non-grey list
investment destinations.
I do not understand why New Zealanders should be discouraged from investing in low
tax countries (which is the result of the grey list bias). Foreign taxes are a cost of
investing, just as labour costs are a cost of that company doing business. There is no
welfare gain for New Zealand households or the Government by encouraging New
Zealanders to invest in high tax regimes (which is what the grey list represents).
Thirdly, through an act of serendipity, foreign conduit vehicles in the grey list provide
opportunities for New Zealand investors to access global stocks on capital account,
and avoid the FIF rules. Do we honestly think that these CIVs are the best in the
world? And why should they be preferred to CIVs that may be prevalent in non-grey
list countries?
THE TAXATION OF CIVS
There are effectively two boundaries in this area, namely the boundaries amongst
CIVs that potentially hold the same assets, and the boundary between the taxation
regime applicable in CIVs and that prevailing for the individual. The net effect is that
investors who are committed to using CIVs can be expected, a priori, to choose
vehicles based on their effective tax rate, despite underlying assets being the same in
each case.
Figure 4 illustrates that it is rational for committed CIV investors on 39% tax rates to
use superannuation schemes and insurance products as their preferred savings vehicle,
while 19.5% taxpayers should use unit trusts, other things being equal.
12
Figure 4: Vehicle/marginal tax rate boundary
INVESTMENT VIA A SUPER FUND
$100K
$100K
$6.7K
NZ Investor 39% C/A
$10K TCG
NZ Super Fund R/A
NZ Co
No claw-back
on distribution = $6.7k in pocket
INVESTMENT VIA A UNIT TRUST
NZ Investor 39% C/A
$100K
$100K
$6.7K+3.3K ICs
$10K TCG
NZ Unit Trust R/A
NZ Co
Dividend of $10K – 6% claw back = $6.1K in pocket
The evidence to support this behavioural expectation is anecdotal. However, the
evidence, such as it is, would suggest that (counter intuitively) a reasonable
proportion of savers are 19.5% taxpayers. Perhaps other reasons, such as employer
contributions, may be driving this behaviour. As far as I am aware, no public data is
collected on the marginal rates of investors using different CIVs.
SUMMARY
It is clear to me that tax is driving investment behaviour. This adds to transition costs
in that, as Appendix III (a summary of a recent Treasury working paper) discusses,
the resulting misallocation of resources may be contributing to a lowering of our
potential economic growth rate.
13
Chapter 4
Options for reform
SYSTEMIC THINKING
When approaching the options I was very conscious of the need to apply synthesis
thinking to understand the “system” under examination, the rules for taxing
investment income. A “system” is a “whole that cannot be divided into independent
parts without loss of its essential properties or functions”,11 hence the illustration on
the cover page. If we were to try to improve one part of the system, as officials
attempted to do with the issues paper issued last year to address the taxation of noncontrolled foreign equity, the performance of the whole system may not be improved.
This is because in a modern deregulated economy, capital is mobile across
boundaries.
I do acknowledge that a weakness in my brief from the Minister is the exclusion from
examination of the taxation of income from New Zealand assets where the investor
does not use a CIV. However, the addition of domestic assets held by CIVs to
offshore portfolio investment to the reform agenda is an improvement in holistic
thinking. Additionally, if the options provide flexibility for further sensible reform
then we have an improved outcome.
What is most important is that I attempt to move beyond simply an optimal solution
under current thinking, to a different conceptual framework where the problems can
be eliminated and the taxation regime can get closer to the principles outlined earlier.
ADVANTAGES AND DISADVANTAGES
The advantages and disadvantages of the various options should be read in light of the
objective of the consultative process, namely “the minimisation of the extent to which
the tax system distorts the way New Zealanders invest (direct versus via an
intermediary or via different intermediaries)”. The intention of the Terms of
Reference was to limit the scope for reform to offshore portfolio equity (directly held
and through CIVs) and CIVs holding domestic portfolio equity. The options therefore
do not consider domestic portfolio equity held directly. Some options reduce the
distortions outlined in Chapter 3 but do not eliminate them. My preference is to aim
for greater simplicity at the expense of accuracy when this tradeoff is confronted.
11
Recreating the Corporation, Russell L Ackoff, Emeritus, Wharton School at the University of
Pennsylvania, 1999.
14
Onshore CIVs
only
Income Calculation
Vehicle/Marginal Tax
(a) IST
1. Tax in the CIV
(a) Tax on managed fund
vehicle with credit for tax
paid
(b) Final tax at variable rates
(b) Shift
capital/revenue
boundary
Offshore CIVs
and offshore
direct equities
only
(a) IST
2. Flow through
(a) Withholding tax at proxy
rate deducted and paid at
source with investor wash
up
(b) Withholding at variable
rates deducted and paid at
source
Not applicable
NZ assets held directly – outside scope
THE OPTIONS
(b) Comparative
Value
The matrix above was constructed by officials when they were responding to my
requirement for a simple, integrated flipchart presentation of the options available to
mitigate the tax boundaries detailed in Chapter 3. The matrix elegantly integrates
potential solutions to the three relevant problematic tax boundaries, namely,
capital/revenue, offshore/onshore, and CIV tax rates/investors’ marginal tax rates; and
of course the boundaries overall relationship with direct New Zealand assets, which
lies outside my Terms of Reference. My sphere of influence was to reduce the
distortionary tax treatment of everything inside the matrix.
Before reviewing the options available I want to articulate a prospective definition of
a CIV.
WHAT SHOULD CONSTITUTE A CIV?
For the purposes of the consensus building process I have come to the conclusion that
the definition of a CIV should be a vehicle that owns a portfolio of securities where
that entity owns no more than 10% of the issued capital of the underlying company
and has no control over the company, and where each individual owner of the vehicle
owns no more than 10% of it. Ten percent is an appropriate boundary as it is an
internationally accepted distinction between portfolio and non-portfolio investment.
In addition, a business activity test should be developed in order to ensure that a
vehicle’s main function was managing investments. This means that unit trusts,
defined contribution superannuation schemes, GIFs, and life insurers’ savings and
annuity products should be included within the CIV definition.
15
Closely held entities (such as some partnerships and some venture capital funds)
would not come within the proposed definition because of avoidance concerns.
Furthermore, where the current benefit of the investment is not directly linked to the
current market value of the CIV’s underlying assets, or where there is no accurate
surrender value such as for certain life policies or defined benefit superannuation
schemes, these would not fall within the definition. The reason is that these vehicles
cannot equitably assign income to each beneficiary.
DEFINITION OF INCOME FOR ONSHORE ASSETS
The options are either an Investment and Savings Tax (IST)12 or a shift in the
capital/revenue boundary, to the point where capital gains on equity are tax-free and
tax is paid on all other forms of income (e.g. rent/interest/dividends).
Investment and Savings Tax (IST)
This title is a simple umbrella term for the variants of the risk free return method
(RFRM) proposed over the last four years in New Zealand – the real RFRM, the
nominal RFRM method and the standard return method. Each variant has similar
features. Essentially, at the beginning of each tax year, a universal rate of return on a
portfolio of assets is assumed (i.e. ex ante). Taxable income is calculated by applying
that rate of return to the dollar value of the portfolio at the commencement of the tax
year. The tax due on that income is based on an investor’s marginal tax rate and is
paid at the end of the tax year. Returns above the assumed rate are tax-free; returns
below the assumed return still require payment of the tax. The relevant formula is
provided below:
Opening value * assumed rate of return * investor’s marginal tax rate
Depending on the method chosen, an IST moves our taxation regime closer to the
principle of taxing full economic income. If returns to risk are considered to be
entirely random, given a level of risk, then the Government should be indifferent
between obtaining a share of positive returns to risk and returning a share of losses
from risk to taxpayers. The essentially random nature of these returns would suggest
that Government is in no better position after the tax compared with the position
before the tax.
The Government could capture the expected value of a positive return to participation
in financial markets by directly investing in equity. Assuming the Government does
not want to hold equity directly, the average portion of positive return that the
Government will collect over time would depend on the IST benchmark used.
Whether a tax approach based on this logic meets the objective of taxing (on average)
full economic income would depend critically on the rate. The IST rate that would
12
My thanks to Louis Boulanger for conceiving this title.
16
get us closest to taxing full economic income would be one that proxied expected
average dividend yield plus capital gain.
An IST represents a shift from traditional transaction-based taxes applied ex post,
such as a typical capital gains tax, where the Government and the investor are exposed
to the full volatility of equity cycles, to an ex ante tax on a low “risk free” rate, where
the investor collects all capital gains above the risk free rate, in return for which the
investor pays the tax through all equity cycles. The Government’s taxation revenue
exposure shifts from an equity-like profile to one that has a profile closer to debt, in
which case revenue volatility is reduced.
An IST removes the uncertainty of the capital/revenue boundary – since the definition
of what is capital and what is revenue is redundant. It replaces dividend taxation.
The potential for error when estimating provisional tax reduces under an IST. Tax
losses are no longer generated. IST liabilities would be reduced to the extent that
imputation credits are available from portfolio investments.
In terms of whether an IST gets us closer to the after-tax treatment of direct portfolio
investment on capital account, it may, depending on the IST rate. In the short term
there may be mismatches. However, while an IST may move the income tax
treatment of CIVs closer to the income tax treatment of direct investments, it will not
be equivalent. Direct investors on capital account will be indifferent between the two
regimes if the ex post tax on their underlying portfolio’s dividend yield is the same as
the ex ante IST on income from a CIV.
Direct investors on revenue account should have a schizophrenic response. When ex
post returns are higher than the IST rate, they should prefer to use a CIV; when total
returns are negative they should prefer the status quo since they can claim a tax credit
for capital losses. However, in both cases revenue account investors cannot predict ex
post market returns.
Alternative IST rate setting methodologies
A higher IST based on expected dividend yield and capital gains will be closer to a
tax on full economic income. A lower IST will be closer to the tax treatment of direct
New Zealand equities. I have considered the following three methods:

Real risk free return method. The McLeod Review proposed a single risk-free
rate of return applicable to all investments in the ambit of the regime. The rate
would be based on New Zealand Government debt with a one-year term to
maturity, adjusted for expected inflation over the year in question. This
methodology is transparent and is credible because it is linked to deep liquid
markets.
17

Nominal risk free return method. This replicates the first method, but does not
adjust for inflation, on the basis that our existing income tax system is largely
not inflation-adjusted.

The standard return method. This method, which is nominally-based, would be
set by Government fiat. Officials have suggested referencing the standard return
rate to New Zealand dividend yields. The rate setting methodology is simple but
less transparent. The Netherlands Government has introduced an IST (known as
an “investment yield tax”) set at 4% on net assets.
I do not know whether the real risk free return method or the nominal risk free return
method get us closer to the taxation of full economic income. This is because it is
unclear whether one-year Government bond yields (adjusted for inflation) equate to
expected dividend yields and capital gains (also adjusted for inflation). The standard
return method appears to gets us closer to the taxation treatment of direct New
Zealand equity.
Other IST issues

Opening market value/base value. The IST should be applied by multiplying an
income tax rate by the IST assumed rate based on the asset value of an
investor’s portfolio prevailing at the commencement of the tax year. This
presumes a readily identifiable market value for relevant assets, where pricing is
not discontinuous.

Part-year adjustments. Considerable work has already been undertaken by
officials to resolve the issue of applying an IST regime to capital contributions
and withdrawals over the course of an income year. I am not satisfied that this
work has yet reached a degree of simplicity required for successful
implementation of an IST regime. I am confident that a simple solution could
be found.

IST cash flow mismatches. Inevitably, at some stage, market circumstances will
dictate that IST liabilities will exceed actual income during a tax year. This is
analogous to a New Zealand direct investor on capital account who always pays
tax on dividends despite fluctuating share prices; or the payment of tax on rental
income despite fluctuating house prices. In both cases effective tax rates will
vary according to actual returns. CIVs will be required either to maintain cash
or income assets to prudently cover this known liability, or to sell assets. This is
easily conceived while the tax liability rests with the CIV. When the liability is
pushed out to beneficial investors under the flow through option a “unit selldown authority” mechanism will be required to facilitate the payment of tax,
since there is no cash flow
18

Compliance costs. The introduction of an IST means CIV tax accounting teams
will be required to take into account an IST regime. However, the need to
account for tax on dividend and capital gains would cease.
Shifting the capital/revenue boundary
This option proposes a shift in the capital/revenue boundary to the point where tax is
not paid on capital gains on New Zealand equity but remains on all other forms
income (rents, interest, dividends, etc). A shift such as this would be equivalent to the
tax treatment of direct investment on capital account. The capital/revenue boundary
would become well defined, eliminating uncertainty. The potential for estimation
errors for provisional tax is reduced, but not to the same extent as under an IST. Tax
losses in the CIV are eliminated. Accounting for capital gains taxation on domestic
equity is removed. Inland Revenue rulings on passive funds would be redundant.
This option gets us closer to the prevailing tax treatment of direct equity investment
on capital account. A major weakness is that it does not get us closer to taxing full
economic income, and is less consistent with either option presented for the taxation
of portfolio investment from offshore.
Where retail CIVs interpose intermediate wholesale CIVs for their equity investment,
an issue arises on how to distinguish between the capital gains component and the
taxable income component when all that the retail CIV receives is a single gross unit
price. This would need to be resolved.
Common issues
Both options presented create a “brightline”, since the uncertainty over the
capital/revenue boundary is either shifted and legislated, or eliminated. Transaction
costs for providers and investors are reduced, and because tax liability is clear, the
Inland Revenue can become more effective in monitoring compliance.
Income tax liabilities would be reduced to the extent that domestic imputation credits
and credits for foreign non-resident withholding tax are available from portfolio
investments. Under both options expenses would continue to be deductible according
to current tax rules.
All options eliminate uncertainty over the definition of “income” for onshore equity.
Income under either definition can be taxed in the CIV (option 1(a) or 1(b)) or
flowed-through and taxed to the beneficial investors (under 2(a) or 2(b)). All options
require an identification of what constitutes a CIV in order to protect investors using a
CIV with a “safe harbour”. This safe harbour ensures that the actions of the CIV do
not taint the capital/revenue status of the beneficial investor. However, if the
investor’s activity or purpose in investing in a CIV so determines, the investment may
be on revenue account.
19
TAXATION OF INCOME FROM OFFSHORE PORTFOLIO EQUITY
There are two options to tax income from offshore portfolio equity. These options
would apply to offshore investments through CIVs (New Zealand domiciled and
overseas) and to offshore assets held directly. The options presume that the current
grey list disappears for portfolio equity, which means that New Zealand investors can
switch from high tax to low tax jurisdictions without a change in tax treatment.
It is important to note that as the New Zealand Government cannot tax a foreign entity
on its non-New Zealand sourced income, it must tax New Zealand investors as a
proxy for the foreign entity. Because New Zealand investors and their advisors have
the capability to reduce taxable income by exploiting the capital/revenue boundary in
respect of offshore assets, and because the compliance and monitoring costs of
looking through foreign structures to the final investment is prohibitive, it makes
sense to tax full economic income. In addition, deferral opportunities make it sensible
to tax this income on an accrued basis.
Regardless of the options, a New Zealand CIV which holds foreign portfolio assets
and has flow through tax treatment may be less attractive to some New Zealand
investors who might enjoy some timing advantages from holding the same underlying
foreign portfolio assets directly or in a foreign CIV (the timing advantage relates to
the deferral in filing a tax return). The quid pro quo is the compliance costs
associated with filing tax returns.
Both options apply to all foreign CIVs regardless of the underlying assets. If those
assets are, for example, global fixed income assets the accrual rules will not apply, as
at present. It is difficult to say whether that would create a greater investor preference
for CIVs taxed under these options relative to existing grey list arrangements.
Investment and Savings Tax (IST)
The prospective features and principles of an IST offshore are similar to an IST on
domestic assets. Credits for foreign non-resident withholding taxes would be
available but not credits for underlying foreign tax paid by the entity.
While all three rate setting methodologies are available for an IST on offshore
equities, they have a different starting point. The real RFRM would be based on
global Government debt (adjusted for expected inflation over the coming year). The
rationale for the difference is that the investment is in foreign assets. Where global
Government debt is hedged back to New Zealand dollars, the currency gains are taxed
under the accrual rules and parity reigns. The nominal RFRM rate replicates this but
does not adjust for inflation. The standard return method using a global dividend
benchmark is further away from taxing full economic income, and there are issues
around the selection of the appropriate dividend yield (e.g. US, global?). It is not
obvious that this benchmark is consistent with any other tax boundary.
20
Compliance costs rest with the New Zealand investor, whether it is a CIV, other entity
or an individual. I do not believe compliance costs will change much since, in most
instances, the requirement for filing tax returns to account for dividends will be
replaced by an IST return. Risks associated with incorrectly calculating one’s tax
liability must diminish since capital/revenue boundary issues disappear.
There is a clear tension between the convergence of this option with the domestic IST
option, and the divergence from the remaining FIF regime for foreign assets where
ownership is greater than 10% but does not represent a controlling interest.
Comparative value
This option is based on one of the existing four income calculation methods available
under the FIF rules.13 It does attempt to tax full economic income. The change in the
market value of offshore portfolio assets and any distributions are deemed to be
income (or losses) for the year and are taxed. The officials’ issues paper suggested
taxing 70% of the change in asset value in the year. This method, when combined
with removing the grey list, was broadly revenue neutral. Credits for foreign nonresident withholding taxes would be available but not credits for underlying foreign
tax paid by the entity.
This option can also create potential cashflow complications, since exchange rate
fluctuations mean taxable income can vary from actual income.
I do not have any reasonable economic rationale for suggesting that 70% or any other
rate is appropriate.
This option is more consistent with the FIF regime prevailing for New Zealand
investors who have a greater than 10% non-controlling interest. In terms of
consistency with domestic options, it is not immediately clear whether this option is
preferable.
13
The FIF rules provide the following methods for calculating income in respect of an offshore
investment:

Branch Equivalent – taxable income is calculated as if the foreign entity invested into were a NZ
branch;

Accounting profits – taxable income is calculated as the investor’s share of a foreign company’s
net, after-tax accounting profit;

Comparative value – taxable income is calculated as the net change in value of a FIF interest and
any distributions derived; and

Deemed rate of return – taxable income calculated by applying a deemed rate of return to the
book value of the investment at the start of a tax year.
21
CIV AND INVESTOR TAX ALIGNMENT
Options 1(a) and (b) in the matrix provide alternatives under a regime where the
liability for income tax resides within the CIV. Tax on the income of the managed
fund with a credit for tax paid (option 1(a)) replicates the current treatment of unit
trusts. A single proxy rate provides a degree of administrative simplicity and
addresses tax avoidance and, to some extent, deferral concerns. However, business
risks stemming from calculation errors would be high, and tax asset (i.e. accumulated
tax losses) treatment would be inconsistent and opaque across CIV providers. Timing
advantages would accrue to investors on marginal tax rates higher than the proxy rate,
while disadvantages would accrue to investors on marginal tax rates lower than the
proxy rate. In some instances the latter may not be able to use the credits distributed.
In addition, I do not know of an equitable method for setting the proxy rate.
Option 1(b) moves beyond a proxy rate to variable final tax rates in the CIV using
rates of tax reflecting the marginal tax rate of the investor – 0%, 19.5%, 33% and
39%. Such an option, one that puts final variable rates at the CIV level, is unheard of
in a New Zealand context. While it may theoretically be possible, different after-tax
pricing streams from one asset would mean that unit pricing functionality would need
to change. While such an approach would dissolve timing advantages and
disadvantages for investors, it is not clear how CIVs would monitor investors’
marginal tax rates when the liability for tax lies with the CIV.
Both options 1(a) and (b) continue to tax income in the CIV, with option 1(a)
replicating the company model of taxation, including imputation. Under both options,
tax is implicitly included in the calculation of the unit price. This requires CIV
providers to assess the income tax liability of the CIV and deduct this from net-ofexpenses investment returns to generate an after-tax unit price.
Options 2(a) and (b) provide alternatives under a regime where the CIV is not
generally liable for tax and the income tax liability flows through to the final investor.
Both options have implications for the recording of investor details (which is done in
administration/unit registry systems). Both options require CIVs to allocate taxable
income to individual investors’ accounts on a regular (e.g. quarterly) basis – a deemed
distribution. Tax liabilities on deemed distributions of income would be calculated,
deducted and paid on behalf of the investor. The balance of the distribution would be
added back into the investors’ unit balance. All income would be required to be
distributed or penalties would apply. Deemed distributions must be regular to reduce
avoidance opportunities.
22
Option 2(a) would apply a resident withholding tax (RWT) with a wash-up. A tax
calculation and payment on deemed distributions of taxable income at a single
withholding tax rate would be required, with investors required to square up their tax
liabilities through a tax return at the end of the tax year. This option, creates minor
timing advantages and disadvantages for higher income and lower income investors
respectively, and could mean that lower income investors may not be able to utilise
tax credits efficiently. Compliance costs change and shift to the beneficial investor
and the Inland Revenue. Where investors have excess tax to pay of $2,500 or more
they would be required to pay provisional tax.
Option 2(b) would be similar to the current arrangements for bank deposits, whereby
investors provide their prevailing marginal tax rate to the CIV provider at the
beginning of the tax year. Withholding at variable rates dissolves the timing and use
of tax credit disparity issues associated with option 2(a). It successfully integrates the
entity and investor marginal tax regimes. Compliance costs (systems upgrades)
would be borne by the provider.
Both options increase administrative complexity but reduce business risks for CIVs.
Transparency of performance would improve considerably because tax management
would be removed from the unit price. In addition, the tax liability shifts from the
CIV to the investor.
23
Chapter 5
Stakeholder reaction
THE PROCESS OF GATHERING VIEWS FROM THE INDUSTRY
I took the view that if policy was going to move forward then part of the Terms of
Reference had to include wide consultation of different and in some cases competing
industry groups, firms and individuals. In my own experience, I found the
consultation of financial intermediaries during the gestation of GST in the mid-1980s
to be a relevant benchmark for the successful implementation of policy change.
This consultative process was intensive, with over 70 parties identified for or asking
for a face-to-face meeting or sending in comments (a full list of stakeholders
consulted is contained in Appendix II). I was accompanied on most occasions by tax
policy officials from the Inland Revenue and the Treasury. The format of the
meetings took the form of a flip chart presentation on the objectives and constraints of
the consultative process, the history and context of my Terms of Reference, the
importance of efficient financial intermediation for economic growth, general taxation
principles, the relevant tax boundaries and the consequent distortions, and finally
options for reform.
Stakeholders welcomed the opportunity to discuss the issues. I am informed that this
has been one of the widest ranging and most intensive consultative processes between
tax policy officials and a relevant community of interest. As a consequence, I
received a large number of written responses to my presentation which have helped
me understand the advantages and disadvantages of prospective changes. I am very
grateful for these views.
CONSENSUS ON THE OBJECTIVES OF THE CONSULTATIVE PROCESS
A clear consensus was expressed that New Zealand’s tax policy should deliver greater
consistency of tax treatment on investment income.
CONSENSUS ON THE PROBLEMS CONFRONTED
There was a general consensus that it was our unique tax treatment of different
boundaries that has led to economic distortions, higher transaction costs and a
misallocation of scarce capital. Most considered the implicitly different definition of
income for direct versus indirect investment to be the most important boundary. Clear
evidence was produced that the cost to industry and ultimately investors of defining
and monitoring the existing capital/revenue boundary was significant, and yet, in the
24
absence of legislation or definitive case law, compliance was problematic, and
industry was still none the wiser of the boundary’s whereabouts. An appreciation was
gained on what these economic distortions might mean for New Zealand’s economic
growth potential.
CONSENSUS ON THE OPTIONS FOR CHANGE
There was clear consensus that I had identified the viable options for change within
the Terms of Reference given to me. Other options mooted were variants of the
options presented or were not viable, in my view. Some, such as the extension of the
reforms to direct investment in New Zealand assets or a flattening of the income tax
scale, while economically sensible suggestions, were not part of my Terms of
Reference. When stakeholders confronted the accuracy-simplicity tradeoff they
expressed a clear preference for simplicity.
CONSENSUS ON THE TAX TREATMENT OF CIV INCOME
An overwhelming preference was expressed for a shift in the capital/revenue
boundary to the point where the definition of “taxable income” for domestic equity
gains in a CIV was in line with the tax treatment of direct investments on capital
account. In addition to equivalence, business risks from accounting for tax,
administration costs, and cashflow timing matching were given as advantages. Some
considered that no change was necessary since current rules are the same for both
investment channels, but an effective Inland Revenue compliance monitoring regime
for individuals and a clear “brightline” for defining the capital/revenue boundary were
both missing. Some considered trustee conservatism over the tax treatment of income
in CIVs to be the cause of the relative tax disadvantage.
A number of stakeholders raised the issue of distinguishing between the capital gains
and taxable income components of a intermediate/wholesale CIV, which will
generally only publish a gross unit price.
There was some support for a shift from traditional transaction-based taxation to an
IST. The reasons given were alignment with their preferred offshore solution, a
superior tax on economic income, certainty of taxable income, and a reduction in tax
receipt risks for the Government, while still moving closer to the tax treatment of
direct investment on capital account since the IST would replace dividend taxation.
Issues to be resolved should the Government introduce an IST included selling the
concept to investors; the funding of tax liabilities when actual income is lower than
the tax liabilities; the methodology for setting the rate; opening market values/base
values; and part-year adjustments (capital contribution or withdrawals).
25
CONSENSUS ON THE TAX TREATMENT OF OFFSHORE PORTFOLIO
INVESTMENT
There was a grudging acceptance that the tax treatment of offshore portfolio equity
investment necessarily has to be different from onshore investment because the New
Zealand Government does not collect the tax on the foreign profits of foreign entities.
Disagreement was expressed, however, with the application of the FIF framework,
which effectively provides a deduction for foreign tax paid by the foreign entity rather
than a credit.
Most stakeholders’ submissions argued for the abolition of the grey list exemption
and for an accompanying change in the FIF regime for portfolio investment. The
principle rationale given was the distortions created by the boundary of the grey/nongrey list regimes and with onshore CIVs. Of those that advocated change, all
preferred an IST regime over a comparative value regime. The rate of IST and the
rate setting methodology were critical pre-conditions for assent. Despite this
preference, very few stakeholders were able to enunciate a preferred methodology for
setting the IST rate. Of the limited few that expressed a preference for an IST rate
setting methodology, global real bond yields were preferred.
A much smaller number argued for the retention of the status quo or an extension of
the grey list. Reasons given were:

the loss of favourable tax treatment;

that the appropriate policy response to the grey list distortion is to extend the
favourable treatment and to manage consequential leakage on a case-by-case
basis; and

that New Zealand risked the emigration of high net worth investors whose
capital is mobile.
CONSENSUS ON THE DEFINITION OF DOMESTIC CIVS
Most stakeholders supported a comprehensive definition around the concepts of
“widely-held” entities which held portfolios of securities the individual shareholdings
of which were no more than 10% and no effective control was exercisable over the
company issuing the securities. Effectively, this should mean unit trusts, GIFs,
superannuation schemes, and life insurance products, and investment companies could
be included. Issues are outstanding on how to include defined benefit superannuation
schemes and some insurance products. It is not envisaged that some venture capital
and closely-held partnerships would meet the definition.
26
CONSENSUS ON THE ALIGNMENT OF TAX TREATMENT OF
INVESTORS USING NEW ZEALAND CIVS
Of those who commented on this issue, complete consensus was expressed for flow
through tax treatment for CIVs. All stakeholders wanted taxation liability moved
from the CIV to the investor, which would replicate the tax treatment of individuals
investing directly.
Of the two options presented for this form of treatment, a very strong preference was
expressed for the introduction of a withholding tax treatment (at the investor’s
nominated marginal tax rate). The strong caveat to this support was the quantification
of transition costs. The fallback option was the single withholding rate option.
I did receive some comments that these particular issues replicated TOLIS.14 If the
vehicle/marginal tax rate was the only boundary being reviewed, I might have met
resistance to change. However the passage of time, improvements to technology and
the linking of this reform to reforms of the other tax boundaries have clearly reduced
resistance to change.
CONSENSUS TO MOVE FORWARD
Almost all stakeholders argued for a move forward from the status quo. It should be
emphasised that in the time available, and in the absence of final direction, some
stakeholders were unable to provide objective support for combinations of options
pending completion of transition cost estimates.
14
Taxation of life insurance and superannuation fund savings, a report to the Treasurer and the
Minister of Finance and Minister of Revenue from the Working Party on the Taxation of Life Insurance
and Superannuation Fund Savings. April 1997.
27
Chapter 6
My view of the options and recommendations for
change
The development of options which minimise tax distortions was the core objective of
the consultative process. I believe that the consensus of stakeholder views clearly
signalled a more consistent outcome for the tax treatment of investment income than
at present. There is therefore a strong base for refinement and legislative change.
MY VIEWS
My only difference with the majority of stakeholder views is a preference for an IST
on domestic equity gains derived through CIVs, with the same rate setting
methodology for an offshore and onshore IST.
Stakeholders’ preferred options for the tax treatment of CIVs and offshore portfolio
assets are compatible with minimising tax distortions and improving the consistency
of tax treatment across boundaries. However, changing the definition of “taxable
income” by shifting the capital/revenue boundary for domestic equity gains derived
through CIVs is, in my view, inferior to the IST option, since an IST gets closer to
taxing full economic income and is consistent with the preferred offshore option. I
therefore favour the IST option subject to the rate setting methodology.
The IST rate setting methodologies set out in Chapter 4 describe differences,
depending on whether the assets are New Zealand or offshore. From an investor’s
perspective, this does not seem reasonable. Policy from a national welfare
perspective may differ from an investor perspective. In this case national welfare
concerns may include avoidance (such as the potential for New Zealand investors to
use offshore vehicles to access New Zealand assets with lower tax relative to
investment in these assets directly) and capital flight (imperfect markets may result in
a preference for offshore assets). The impact of the latter may affect capital-raising
opportunities for New Zealand borrowers. Setting a higher IST rate on offshore
portfolio equities may also lead to sub-optimal outcomes as it would affect adversely
sensible investor diversification strategies.
The summary of these views is that the offshore IST should not be different to the
onshore IST, and both should not be lower than nominal New Zealand Government
bonds.
28
My preferred option is a single inflation-indexed IST rate. Realistically, however, if
we were to introduce an inflation-indexed IST there would need to be a clear
commitment from the Government to inflation-index the rest of the income tax
system. Otherwise inconsistencies would arise. So far, Government commitment to
inflation indexing has not been forthcoming. Without such a commitment, a secondbest rate-setting methodology should approximate New Zealand Government bond
yields. Investors would have to be content that this may rise or fall in each tax year.
If issues arise around prospective rises and falls of a market linked IST, the
Government should set an acceptable fixed rate.
TERMS OF REFERENCE
The Terms of Reference required that “any changes should, as far as possible:
a)
protect the New Zealand tax base from erosion;
b)
minimise compliance costs;
c)
minimise the extent that the tax system penalises lower income savers who may
not have the means or the skills to invest directly and for whom employment
superannuation is a likely to be significant for retirement savings.
My comments on these caveats are as follows:
a)
Protecting the New Zealand tax base
Proposed options for change will mean that the Government faces fiscal costs.
However, to the extent that the existing tax base already faces erosion problems, it is
desirable to move to an economically sustainable, comprehensive and fairer basis for
the taxation of investment income.
It is important to note the fiscal costs of moving from the current regime to the
stakeholder preferred combination of reform options. The static costs of a shift to the
stakeholders’ preferred options is likely to be in the low hundreds of millions of
dollars. A detailed costing should be undertaken when the proposals are more fully
developed. This ignores potential dynamic gains from the introduction of a
comprehensive regime and the redistributive effects on investors who face a different
tax regime.
b)
Minimising compliance costs
Different options create different compliance costs for the Government, industry and
investors. The preferred options will result in a sharing of these costs. These costs
need to be linked to the benefits from a reduction in tax distortions.
29
Industry compliance costs are concentrated within the preferred options proposed for
aligning the taxation of CIVs and the marginal rate of their investors. Principally, the
costs relate to upgrades to systems. I have endeavoured to scope costs using the
advice of third party systems suppliers and do not believe that the costs are
insurmountable.
On their own, the cost of these changes may be problematic. It is therefore highly
desirable that if these changes are implemented, they are accompanied by changes to
the definition of “taxable income”, where the costs of compliance are much smaller,
but the benefits considerably larger. Additional costs may be incurred by suppliers
from the alignment of investor tax rates through CIVs as providers move to rationalise
product. The tax rationale for offering different products would be redundant.
Stakeholders were also concerned about part-year adjustments under an IST. A
potential solution for investment through a CIV is to look at applying the IST to daily
market values. This would mean that the final tax liability would represent an average
through the tax year. This would eliminate the part-year adjustment complexity and
would mitigate investor avoidance issues.
Government’s compliance costs are mainly concentrated in the options proposed for
the redefinition of “taxable income”, which would require changes to administration
systems (leaving aside the larger issue of fiscal costs of a regime change).
Investor costs are concentrated in the proposed IST following the removal of the grey
list for offshore portfolio investment, which will alter tax liabilities. Compliance
costs should not change as filing tax returns for dividends will effectively be replaced
by filing an IST return. In the time available, I was not able to give enough thought to
the level of a de-minimis threshold that would exempt an investor from an IST
regime.
c)
Lower income savers
Savers on marginal tax rates of 19.5% or less are penalised when using tax-paid CIVs
such as superannuation schemes or life insurance, or where CIVs treated as companies
for tax purposes distribute income (with excess and partially unusable credits
attached). The preferred option for the taxation of CIVs largely dissolves this
problem. However, there are several consequences that need to be thought through.
30
Beneficiaries
The interaction of the income tax system with the abatement of benefits upon
receiving more income was acknowledged as an issue following the introduction of
the Government’s recent Working for Families package. This package will create
high effective marginal tax rates (EMTRs) in certain circumstances (see Appendix V).
Theoretically, beneficiaries with high effective marginal tax rates should be saving
through tax-paid vehicles now, such as superannuation schemes, since they receive an
obvious tax benefit. If the Government accepts the flow through option for taxing
CIVs, beneficiaries who save through CIVs will receive more taxable income and
their benefits will abate. An illustration of the abatement regime is also included in
Appendix V.
I have no empirical evidence that such beneficiaries, per se, are an important source of
savings. I therefore recommend that the proposed changes to the taxation of
investment income are not altered to suit this class of investors. If the Government is
concerned about the issue it should be addressed explicitly through altering how such
benefits are administered.
Tax-exempt entities
Tax-exempt entities such as charities find tax-paid CIVs inefficient and cannot use
imputation credits distributed by unit trusts, GIFs or companies. The only advantage
they will derive from the preferred combination of options is the proposed flow
through tax treatment for CIVs where those CIVs hold debt instruments. CIVs which
hold equity are still inefficient for tax-exempt entities as imputation credits are unable
to be used.
Workplace superannuation
The taxation of workplace superannuation was specifically raised by the Savings
Product Working Group as an issue which may alter the conclusions of the Group’s
report, released in early September 2004.15 In terms of the crossover with my work,
the Group specifically was interested in:
“–
The divergence between the marginal tax rate of the individual
saving/investing through a managed fund and the tax treatment of the
vehicle through which that saving is taking place;
–
The matter of the tax treatment of capital gains made by such funds (the
business and purpose test rules).”
15
A Future for Work-Based Savings in New Zealand, Final Report of the Savings Product Working
Group, 31 August 2004.
31
I believe that the consensus-derived options solve the Group’s concerns, since flow
through preserves investors’ correct marginal tax rates, with potentially no more
compliance for the investor, and the business and purpose tests disappear for CIVs in
relation to domestic equity.
However, there are issues to consider. Firstly, transition costs will be required to
improve CIV unit registry, and employer-based superannuation scheme administration
systems (which calculate entitlements, income distributions and taxation liabilities for
investors). These will be required to record the correct marginal tax rates and
liabilities of investors.
CIV providers use a variety of unit registry software systems, from proprietary-based
to third party-sourced, but only one CIV product (a category of GIFs) record tax
liabilities on income at the correct marginal rate of tax.
Many employer-based schemes outsource investor record keeping functions to third
party administrators who have different systems. If the flow through option is to be
pursued, and I recommend it is, then some time must be given to suppliers to cost the
changes, and it must be accompanied by changes to the definition of taxable income.
This will provide a reason for businesses to upgrade or invest in new platform
technologies.
In addition, the proposed definition of CIVs currently excludes defined benefit
employer superannuation plans. It would be more consistent if they were included but
time has not permitted sufficient exploration of how this could be achieved.
MAIN TRANSITIONAL ISSUES
Communication of the IST
The most obvious communication issue is how investors should position their
portfolios in response to the known annual tax liability generated by the introduction
of an IST. We do not have information on where investors’ growth/income asset mix
is positioned now, and therefore whether they should become more or less risk averse,
given the required cashflow to meet IST liabilities. However, it seems to me that
because the tax liability is known from the beginning of the tax year, no one should
have any excuses for not planning for its payment at the end of the tax year. In other
words, investors should always hold cash or income assets to cover the known
liability.
If legislators are concerned at the prospect of the “Holmes effect” – media
amplification of constituents complaining of having to pay tax when total returns are
negative – then I have little sympathy because:
32

investors pay tax on dividends now when total returns are negative;

an IST liability is quantified a year in advance of payment, providing plenty of
opportunity for cashflow management; and

if the actual issue is the volatility of equity returns, then portfolio rebalancing
from growth to income assets, not challenging the tax impost, is the
appropriate solution.
Treatment of accumulated tax losses
Some tax-paid CIVs have recently accumulated large tax losses (tax assets) as a result
of falling capital values, principally due to global share prices. These will need to be
preserved if the Government moves to the proposed flow through treatment for CIVs.
Options could include cashing out the losses directly to prevailing investors, or
distributing them as a tax loss able to be carried forward. The preferred solution is for
this to occur at the point at which the reform commences.
33
Chapter 7
Next steps
I made it clear during the consultation phase that my formal contribution to this
process concluded at the end of October 2004. Provided that subsequent public
discussion mirrors issues raised in this document, I would strongly recommend
finessing, costing and implementing the preferred combination of options, with
enough time for stakeholders to cost and plan for the transition.
It is my sincere hope that, after this interactive process, Government and industry and
investors continue to commit to reform. The alternative is not palatable. It is not
obvious to me that a democratic process of consensus building towards an improved
sustainable system of taxation of investment income for New Zealand investors
during a clear window of goodwill can be surpassed as a strong process for change.
34
Appendix I
Terms of Reference
The Government will appoint an independent Chair to ascertain whether a consensus
is emerging on how to address the current problems with the taxation of investment
income, both domestically and offshore. The Chair would be responsible for
consultation on options that are consistent with developing such a consensus. The
Chair would consult widely with the New Zealand savings industry and other
interested stakeholders.
The mandate of the Chair will be to resolve issues and inconsistencies in the tax law,
(primarily as they apply to New Zealand portfolio investors – those under 10%
ownership interests in companies or other entities), whether those investments occur
directly in companies, other entities, or indirectly via intermediaries. It should be
assumed that the basic structure of tax laws outside the area of investment will not be
altered and will therefore be outside the Terms of Reference for this work. An acrossthe-board capital gains tax, taxation of owner-occupied housing and the basic
treatment of debt instruments under the accrual rules are not within the Terms of
Reference.
It would be outside the scope of the work for the Chair to consider alternatives to the
tax treatment of savings that are not consistent with the TTE (tax/tax/exempt) model
applied in New Zealand or to consider savings-related concessions. Some related
specialist areas, such as the tax rules for life insurance may be impacted by any
options put forward. While it would be useful to note these impacts, in the time
available it would not be feasible for the Chair to consider the many detailed issues
that changes to the tax treatment of savings might involve.
In its broadest terms, the Chair should consider options for making the tax law more
consistent between direct and indirect investment so as to improve the efficiency and
fairness of the taxation of savings and in particular to reduce any tax impediments to
the ability of ordinary New Zealanders to save for their retirement.
The objective of this work is to develop options for change that would minimise the
extent to which the tax system distorts the way New Zealanders invest (direct versus
an intermediary or via different intermediaries). As far as possible New Zealand
resident intermediaries should not face tax penalties compared to direct investment
and similar offshore entities New Zealanders might invest in.
35
In meeting the above objective, any option for change should, as far as possible:
(1)
Protect the New Zealand tax base from erosion. Examples include investment in
low or no tax jurisdictions, or investment in no or low tax entities in high tax
jurisdictions.
(2)
Minimise compliance costs for New Zealand investors and the New Zealand
savings industry. For example, any requirement for individual investors who are
currently not required to file tax returns to start filing such returns would
increase compliance costs. Similarly the New Zealand savings industry has
expressed concerns regarding compliance costs imposed on them under certain
current tax rules.
(3)
Minimise the extent to which the tax system penalises lower income earners
who may not have the means or the skills to invest directly and for whom
employment superannuation is likely to be significant for retirement savings.
For example, it would be desirable that those on a low rate of tax are not taxed at
a higher rate on their superannuation savings.
It should be noted that the points above, may at times be, contradictory in practice,
which is why there is likely to be several options proposed along with their
advantages and disadvantages.
Revenue neutrality is not an objective of this work. The Government would like to
consider the most viable options (having regard to the objective and points (1) to (3))
above identified by the Chair, irrespective of their revenue implications. Revenue
implications should however, to the extent possible, be identified since these would
need to be taken into account in any final decision.
The Government considers that the Chair should be charged with:
-
-
-
-
36
Establishing if there is general agreement on whether the objective and points
(1) to (3) above are the principal issues in the area of taxation of investment
income.
Identifying the boundaries that exist in the area of the current taxation of
investment income, both domestically and offshore.
Ascertaining whether a consensus can be achieved on how to resolve problems
associated with these boundaries, in consultation with the New Zealand savings
industry and other interested stakeholders.
Developing options for reform that are consistent with these boundaries, in
consultation with the New Zealand savings industry and other interested
stakeholders.
Developing options for reform that are consistent with such a consensus.
Identifying the advantages and disadvantages of the options considered.
Reporting to the Minister of Finance and Revenue on viable options by the end
of October 2004.
Appendix II
Stakeholders consulted
ABN Amro Craigs
Mercer
AMA Capital Ltd
Milford Asset Management Ltd
Aon Consulting New Zealand Ltd
Ministry of Social Development
Association of Superannuation Funds of New
Zealand
Minter Ellison Rudd Watts
Asteron Life Limited
Morel & Co
Aventine Consulting
Morgan Taylor Ltd
AXA New Zealand
Morningstar NZ
Bank of New Zealand
Northplan
Brook Asset Management Ltd
NZ Assets Management Ltd
BT Funds Management (NZ) Ltd
NZ Business Roundtable
Chris Horton
NZ Exchange Ltd
Cleary Financial Services Ltd
NZ Funds Management Ltd
Consumers Institute
NZ Law Society
Corporate Taxpayers Group
NZ Society of Actuaries
Deloitte
NZ Society of Investment Professionals
Direct Capital Private Equity Ltd
NZ Venture Capital Association Inc
Diversified Investment Strategies Ltd
Paul Dyer
Eriksen & Associates Ltd
PricewaterhouseCoopers
Ernst & Young Ltd
Public Trust
Fidelity Life Assurance Company Ltd
Reserve Bank of New Zealand
Financial Focus (New Zealand) Ltd
Retirement Commission
Financial Planners & Insurance Advisers
Association
Rob Dowler
First NZ Capital
FMG Investment Advisors
Fund Distributors Ltd
FundSource Research Ltd
Greg Dwyer
ING (NZ) Ltd
Institute of Chartered Accountants of New
Zealand
MMc Ltd
Russell Investment Group Ltd
Russell McVeagh
Savings Product Working Group
Securities Industry Association
Select Asset Management
Shortland Management
Sovereign Ltd
Strategic Asset Management
Investment Savings & Insurance Association
of NZ Inc
Tacit Group
John Key, National Party Spokesperson on
Finance
Trustee Corporations Association of New
Zealand
KPMG
Trustees Executors Ltd
Martini Consulting Ltd
Tyndall Investment Management NZ Ltd
MCA Ltd
Watson Wyatt NZ Ltd
Melville Jessup Weaver
Women in Super
Tower Limited
37
Appendix III
“Financial systems and economic growth: An
evaluation framework for policy” – a summary
The full text of this Treasury working paper is
http://www.treasury.govt.nz/workingpapers/2004/04-17.asp
at
available
at
The purpose of the paper is to develop an analytical framework for discussing the link
between financial systems and economic growth. The paper does not attempt to
assess the adequacy of New Zealand’s financial system in providing financial
services. Rather it highlights the importance of financial development for economic
growth and identifies key policy priorities.
Section 2 reviews the role of financial intermediaries and markets and their
comparative advantages in providing external finance to firms. The following
conclusions emerge: first, existing theory suggests a clear link between financial
systems and economic growth. Financial intermediaries and markets can overcome
an information asymmetry in credit markets. They help reduce information and
transaction costs and improve the allocation of resources, leading to faster economic
growth. Second, financial intermediaries and markets offer a range of financial
services to firms that are not complete substitutes.
Section 3 establishes the theoretical link between financial systems and economic
growth. There are two main channels through which financial systems can have an
effect on economic growth: capital accumulation and technological innovation.
The cost of external finance is discussed in section 4. With imperfect information,
capital is only available at a higher real interest rate. The supply curve may even
become positively sloped at some point as the level of external financing increases.
At a country level, the supply of capital may no longer be infinitely elastic, which has
implications for a small open economy. At an individual supplier level, with
imperfect information, the supply of capital curve may become backward bending or
downward sloping, i.e. lenders reduce their supply of funds as interest rates increase,
leading to forms of credit rationing.
Section 5 reviews the empirical evidence on the connection between a country’s
financial development and its rate of economic growth, whether a shift to financial
markets or intermediaries affects growth rates and the importance of financing
constraints. Countries with better developed financial systems tend to grow faster
than countries with smaller banking systems and less liquid financial markets. But
cross-country comparisons do not reveal significant differences between the economic
growth of countries with more market based or more intermediary based financial
systems. The international evidence suggests that finance constraints are empirically
38
important in particular for small firms. The finding supports the theoretical
proposition that credit rationing for some firms may represent a common response by
financial markets and intermediaries as they attempt to resolve information
asymmetries. New Zealand data and empirical analysis to date are limited.
Section 6 discusses the importance of the legal environment and other policy
influences for financial development.
The following conclusions emerge.
Maintaining solid legal foundations is important because the financial system relies on
these. Moreover, a legal system that is able to respond to the financial needs of an
economy fosters financial development more effectively than a more rigid legal
system.
Section 7 assesses the potential effects of the New Zealand tax system on the financial
system. It first reviews the taxation of capital gains and then outlines how New
Zealand’s tax system, which classifies some capital gains as taxable income while
exempting others, acts to distort the investment patterns toward direct investments in
larger and less risky firms or toward passive indexing tracking funds. The section
concludes that removing tax distortions that prevent/lower the production and
discovery of information will lead to increased investment and output. The magnitude
of these effects is uncertain but possibly significant. The economic benefit could be
substantial if resolving existing distortions would increase firms’ ability to borrow in
future. Moreover, additional investment may lead to technological innovation as
firms with high investment in intellectual property or with novel business plans are
particularly affected by information asymmetry and as a result are more likely to face
finance constraints.
Section 8 discusses the main sources of financial instability. It reviews the role of
financial regulation and supervision and briefly examines the regulatory and
supervisory approach in New Zealand. The need for regulation and supervision of the
financial system arises because financial intermediaries and markets, like firms, are
subject to asymmetric information. A key objective for financial regulation and
supervision is to increase the effective functioning of the financial system in order to
enhance the ability to absorb shocks and maintain financial stability. The section
suggests a review of certain aspects of New Zealand’s financial system in the context
of financial regulation and supervision.
Given the importance of financial
development for economic growth, it is valuable to be certain that New Zealand’s
institutional framework and current responsibilities for financial regulation and
supervision are best suited to meet its particular needs.
The last section summarises and concludes.
39
The paper’s appendix outlines insights economics can provide to guide the taxation of
financial intermediaries in a country such as New Zealand that has chosen not to tax
full economic income by not employing a capital gains tax. The appendix suggests
that to tax the capital gains of investors who use intermediaries is to apply a broader
tax base to those investors than to those who use other, non-financial services. A
lower use of financial services and a greater use of other services would be predicted
and firms that rely on intermediated finance are likely to suffer in New Zealand as a
result.
40
Appendix IV
Background to the tax rules for CIVs
Introduction
Currently there is a range of tax treatments that apply to investment entities in New
Zealand. While the entity tax environment may, on the face of it, seem ad hoc a
policy and/or historical rationale can generally be identified to explain the entityspecific rules.
The benchmark for the design of tax rules for investment entities is the tax treatment
of the individual. The tax system should, to the extent that it is possible and practical,
integrate the tax treatment of an entity with its beneficial owners. This means that an
investor should be indifferent to investing via an entity and investing directly. The
caveat on this is that for policy reasons it may be considered desirable to claw back
tax preferences allowed at the entity level (e.g. taxing capital gains distributed as
dividends) and/or to restrict access to entity losses. Nevertheless the useful
benchmark is the tax treatment of the individual.
However, different entities have different characteristics and functions. Therefore, the
extent to which integration is possible, and the means by which this is achieved, will
vary.
Full integration versus company imputation
Essentially there are two approaches to taxing entities. The first approach is to
impose a tax on the entity itself. The second approach is to attribute the tax base of
the entity directly to the beneficial owners (i.e. integration).
It has generally been considered that an integrated model is problematic for widelyheld entities for a number of reasons. First, taxing the beneficial owners on profits of
widely-held entities as they accrue is complex administratively as it would involve
allocating income to each owner and identifying owners’ marginal tax rates. Second,
not imposing a withholding tax on the entity could increase the likelihood that income
is deferred or avoided. In addition, in a discretionary trust context, it would be
extremely difficult to measure (or even approximate) the income that should be
attributed to a discretionary beneficiary before it is actually allocated by the trustee.
41
The company tax with imputation model solves many of these problems for widelyheld entities. It provides a single withholding tax (the company tax) at the entity level
to address administrative, deferral and avoidance concerns. By taxing distributions at
shareholders’ marginal tax rates and providing a credit for company tax paid, the
company tax model achieves a level of integration. This explains the current tax
treatment of companies, unit trusts, GIF As and life insurance.
The history of the taxation of investment entities is quite closely related to the
development of our company tax system. Prior to 1958 dividends were not taxable in
the hands of shareholders (they were however included in the shareholder’s income in
order to establish the investor’s marginal tax rate). Inclusion of distributions for tax
rate calculation purposes raised the question as to why dividends were not taxed as
income. This led to a “classical” company tax system in New Zealand from 1958
until 1988. Under the “classical” system income was taxed at the company level and
again at the shareholder level upon distribution, with no credit provided for the
company tax paid. In 1988 the imputation system for companies was introduced.
The following table provides a summary of the current tax rules applying to the main
types of investment entities and a brief explanation of the history and underlying
policy of the rules.
Entity type
Tax rules/Policy rationale
Individuals
Tax rules: taxation of income (i.e. not of a capital nature) is at marginal tax rates.
Partnership
Tax rules: partnership income is taxed to the individual partners at their marginal
tax rates (“look through” tax treatment).
Policy rationale: under general law a partnership is not a separate legal entity (i.e.
partnership is fiscally transparent and partners are jointly and severally liable).
This explains the current tax rules that tax the individual partners on their share of
the partnership income.
Companies
Tax rules: income of the company (i.e. revenue gains) is taxed at 33%.
Distributions to shareholders are taxed at marginal tax rates with a credit for tax
paid at the company level. Imputation claws-back preferences on distribution to
shareholders (e.g. taxation of any untaxed capital gains of the company). Tax
losses made at the company level cannot be passed through to shareholders.
Policy rationale: the tax treatment of companies has been integrated to a large
extent with the tax treatment of individuals (i.e. rate alignment) with the
introduction of imputation in 1988. The full history is detailed above.
Flowing-through preferences (e.g. capital gains) under imputation was rejected
partly because, on introduction of imputation, companies had significant retained
earnings for which no imputation credits were available. Allowing these amounts
to be distributed with the preferences flowed-through would have resulted in a
significant revenue loss.
Pass-through of losses to shareholders was rejected due to concerns about “fake”
losses in the tax system.
42
Trusts
Tax rules: income is taxed to the trustee at 33%. Beneficiary income (i.e. income
of the trust that is distributed within the income year of derivation or six months
after the end of the year) is taxed at the marginal tax rates of beneficiaries.
Policy rationale: the company tax model was deemed inappropriate on the basis
that, for a trust, property rights are uncertain – i.e. don’t know how many
beneficiaries there are and what their share of the trust’s assets are. Consequently,
it is difficult to have imputation.
Instead, trusts have a final tax (on trustee income) with any income distributed to
beneficiaries as it is earned by the trust (beneficiary income) taxed at the marginal
rates of beneficiaries to provide a level of rate alignment for trust income. Where
a trust distributes income as it is earned these amounts are clearly directly
attributable to the recipient. It is therefore appropriate to tax this income as if it
was earned by the beneficiary.
There is no pass-through of losses. This is based on the trust concept that a
beneficiary should only get positive amounts.
Superannuation
Schemes
Tax rules: taxed as a trust (which they are) but with a final tax at the scheme level
so trust income is not attributed to individuals – i.e. qualifying trust tax treatment.
This means that the income of the superannuation scheme (i.e. revenue gains) is
taxed at 33%. Distributions are tax free, which means that tax preferences (e.g.
capital gains) are not clawed-back on distribution.
Income earned by a superannuation scheme that is distributed immediately is not
taxed at the investor’s marginal tax rate (i.e. there is no “beneficiary income” rule)
on the basis that superannuation should relate to saving for retirement (long-term).
Schemes should therefore not be making distributions as income is earned.
Policy rationale: superannuation schemes were given trust tax treatment as at the
time of introduction of the rules, in the late 1980’s, all schemes were established
as trusts. Prior to this, certain superannuation scheme income received
concessionary tax treatment.
In late 1987, it was announced that the tax treatment of superannuation and life
insurance would be moved onto the same basis as other forms of savings and
investment. Broadly, the main reasons for the reform that led to the current rules
were:
 A move to a broad base and low rate (i.e. removing concessions to make the
rate lower and less variable).
 Treatment according to the type of saving or institutional form through which
saving was channelled distorted patterns of savings by favouring some
taxpayers over others and added to the complexity of the system.
Life insurance
Tax rules: tax is imposed on the life insurance business for profits attributable to
shareholders (the life office base) and also on investment income attributable to
policyholders (the policyholder base). This is the first level of tax. A tax credit is
available to shareholders for tax paid at the first tier. Tax credits also available for
distributions in respect of policyholders (e.g. an increase in actuarial reserves)
Policy rationale: in 1990 the taxation of life insurance was moved to a basis
analogous to the full imputation system applying to companies – i.e. shareholders
and policyholders of a life insurance business treated similarly to shareholders in a
limited liability company. The rationale for this was the provision of insurance
becoming more substitutable with financial intermediation.
Prior to 1990, the taxation of superannuation schemes was limited to the taxation
of investment income.
43
Unit Trusts
Tax rules: taxed as companies. The income of a unit trust (i.e. revenue gains) is
therefore taxed at 33%. Distributions to unit holders are taxed with credits for tax
paid by the unit trust (imputation). Preferences (e.g. capital gains) are clawedback on distribution.
Policy rationale: unit trusts were developed in the 1960s to compete with
investment companies. Legislation was introduced to regulate the management of
the trusts and to safeguard the interests of investors. It was thought logical (at the
same time) to apply the tax law relating to companies to these entities because in
substance they do not differ from investment companies. The history of tax
treatment for unit trusts is therefore linked to the company tax treatment.
Group Investment
Funds
Tax rules:
Category A income – defined as income that is not category B income. This
income is subject to company tax treatment
Category B income – income from designated sources (i.e. income from trusts that
are estates, or are created by statute or Court order). This income is subject to trust
tax treatment
Policy rationale: GIFs were primarily established to get around the company tax
treatment for unit trusts. Tax rules for GIFs were introduced in the early 1980s
and imposed one set of rules on Category A income and another set of rules on
Category B income. The rationale for this is as follows:
Category A GIFs were considered to be competing with investment companies
and unit trusts – therefore received company tax treatment.
Category B GIFs were not competing at this level as they were established to
benefit widows/orphans, etc – therefore received trust tax treatment.
44
Appendix V
Working for Families – effective marginal tax rates,
and abatements
Impact of flow through tax treatment on recipients of family assistance
One of the issues that will need to be considered by Government is the impact of
allowing CIVs to pass through income to investors (for tax purposes) on the
abatements of social assistance received by those savers – that is, savers who are
recipients of family assistance and beneficiaries.
Currently, income is quarantined within certain CIVs (e.g. superannuation schemes)
and so do not affect entitlements to and abatements of assistance. Anecdotally, this
group does not seem to be a significant constituency for the New Zealand savings
industry at present. However, the introduction of the new Working for Families family
assistance package will mean that at the time of its full implementation (in 2008),
savers on relatively high income levels may be recipients of Government transfers.
The graphs below (figures 5 and 6, respectively) outline the effective marginal tax
rate (EMTR) for a single earner family of four (two adults, two children) in receipt of
family assistance, pre and post the full implementation of the Working for Families
package.
The assumptions that have been made are:

the family lives in South Auckland and rents accommodation;

accommodation costs are $300 per week and the family receives an
accommodation supplement; and

the family does not receive any other social assistance.
Figure 5 illustrates the EMTRs faced in the 2005 year. If the market income of the
single earner is $60,000, their EMTR would be approximately 40%.
45
Figure 5: EMTRs in 2005
EMTR
110.0%
Total 2005 EMTR
Tax
Family assistance abatement
Family tax credit abatement
Accomodation supplement abatement
ACC earner premium
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
81,000
78,000
75,000
72,000
69,000
66,000
63,000
60,000
57,000
54,000
51,000
48,000
45,000
42,000
39,000
36,000
33,000
30,000
27,000
24,000
21,000
18,000
15,000
12,000
9,000
6,000
3,000
0
0.0%
Income
Figure 6 illustrates the EMTRs faced in the 2008 year, when the Working for families
package will be fully implemented. For the same level of market, the EMTR of the
single earner would now be 70%.
Figure 6: EMTRs in 2008
EMTR
110.0%
Total 2008 EMTR
Tax
Family assistance abatement
Family tax credit abatement
Accommodation supplement abatement
ACC earner premium
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
Income
46
81,000
78,000
75,000
72,000
69,000
66,000
63,000
60,000
57,000
54,000
51,000
48,000
45,000
42,000
39,000
36,000
33,000
30,000
27,000
24,000
21,000
18,000
15,000
12,000
9,000
6,000
3,000
0
0.0%
Glossary
Capital/revenue boundary – broadly, the boundary that divides investments held for
the purposes of deriving an income stream, such as dividends (capital account
investments) and those that are held mainly for the purposes of deriving a gain on sale
(revenue account investments). The tests under the capital/revenue boundary are not
fully described in legislation. They have a long history in the common law.
CIV – collective investment vehicle, a term used to describe various vehicles used by
New Zealand investors to access a portfolio of investments. These vehicles offer
pooling of risk and opportunities for portfolio diversification. Examples include unit
trusts, superannuation schemes, and life insurance (so called “managed funds”). The
issue of what should be a CIV for the purposes of the options for reform presented is
discussed in Chapter 4.
FIF – the Foreign Investment Fund Rules, the regime that applies for calculating
income from non-controlled equity investments in so-called non-grey list countries.
The FIF rules provide four methods for calculating income from non-grey list
investments, namely branch equivalent (income calculated as if the foreign entity
invested into were a New Zealand branch), comparative value (income calculated as
the change in share value plus dividends derived) and the deemed rate of return
(income calculated based on an assumed rate of return) methods.
Flow through tax treatment – an option for reform whereby income derived by a
CIV would pass through to its beneficial owners. The CIV would become transparent
for tax purposes (like a partnership) with income and the consequent tax liability
resting with the ultimate investor.
Grey list – a group of seven countries: the United States, the United Kingdom,
Australia, Canada, Japan, Germany and Norway. Equity investments in these
countries by New Zealand investors receive a tax preferred treatment – typically only
taxation on dividends derived – relative to investment in other countries which are
subject to the FIF rules. The grey list is based on the assumption that the countries in
it have similar tax systems (and rates) to that of New Zealand, thereby reducing the
incentives for New Zealand investors to use these destinations to avoid tax.
IST – the Investment and Savings Tax, an umbrella term used to describe the variants
of the RFRM proposed over the last four years in New Zealand. Taxable income
under an IST would be calculated by multiplying the opening value of an investor’s
portfolio by an assumed rate of return (the IST rate).
Non-grey list – all countries outside the seven grey list countries. Investments by
New Zealanders in these countries are taxed under the FIF rules.
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Offshore portfolio investment in equity – investment of 10% or less in foreign
equity (i.e. an ownership interest of 10% or less in the foreign entity). The 10%
threshold is the internationally recognised distinction between portfolio and nonportfolio investment.
RFRM – the Risk Free Return Method, proposed by the Tax Review 2001. The
Review recommended the RFRM as a means of rationalising the entity tax rules.
Taxable income under an RFRM would be calculated by multiplying the opening
asset value by the RFRM rate. The Review recommended that the RFRM rate be
based on New Zealand Government bond yields adjusted for inflation (a “real” rate)
Standard Return Method – an option for reform of the tax rules for offshore
portfolio investment that would tax the opening value of such an investment at a
standard rate of return based on a reasonable dividend yield of 4%. The standard
return method was suggested by tax policy officials in an issues paper released in late
2003.
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